Britain’s market regulator, the Financial Services Authority (FSA), unveiled its long-awaited review of Libor, the much-maligned benchmark rate for billions worth of assets across the world, on Friday.
The changes — expected to be accepted by the government and included into current legislation going through Parliament — were indeed sweeping; however, the limits to them highlighted the difficulties of doing anything close to the root and branch changes that some had hoped for.
The review by Martin Wheatley, the head of the FSA (soon to be replaced by a body called the Financial Conduct Authority, also to be headed by Wheatley), was published just three months after the Barclays’ rates manipulation scandal broke, which included further startling revelations about the extent to which the rate — to which some $350 trillion of derivative contracts and $10 trillion of loans are indexed — was fixed at the discretion of banks, and traders with incentives stacked in favour of misreporting data.
The speed at which the review was conducted highlights the sense of urgency in Britain about the importance of restoring the rate’s credibility globally — not to mention the city’s own reputation as a sound global financial hub.
Ahead of the report, suggestions from experts about the potential for reform came in thick and fast: do away with Libor entirely, or base it instead on the actual rate at which banks borrow from one another, rather than the perplexing existing system which uses the rate at which a bank believed it “could borrow funds, were it to do so by asking for and then accepting inter bank offers in a reasonable market size just prior to 11 a.m. London time.”
LIBOR STILL PREVAILS
Neither of those two suggestions has been taken up by Wheatley, who pointed out that for all the damage that had been done to Libor’s reputation recently (while the Barclays story brought the issue into focus this summer, cross-Atlantic investigations date back to 2008), and despite the existence of some alternatives — such as Ronia in Britain or the GCF Repo Index in the US — there has been no serious decline in the use of Libor in the market.
“There is clearly a large role that Libor plays in financial markets for which there is no immediately obvious alternative,” noted Wheatley’s report. Besides, as he pointed out, a transition to a new benchmark would have major consequences for existing swap contracts based on Libor, adding instability in an already volatile market.
Even the decision to change the administering body of Libor — from the British Bankers Association (BBA), which has had the role since the rate’s inception in 1986 to a yet-to-be chosen body — presented complexities, and had required extensive legal consultation about the nature of contracts and whether they would be impacted, as would any changes to the definition of Libor itself.
Adding to the complications is the very varied nature of contracts, with differing legal ramifications.
The regulator is also not recommending that Libor be based entirely on the trades actually done by banks, but rather that submissions be “supported by relevant trade data” — a tacit acknowledgement of the fact that there was a reason why Libor was not designed that way in the first place.
Libor’s success has lain partly in the fact that it is so diverse, giving the market 150 benchmark rates on a daily basis, because it was able to provide a figure across 10 currencies and 15 maturities, including on the most obscure trades for which there is rarely any actual concrete data.
The FSA plans to cut both the currency and maturities gradually, but acknowledged that even for the shorter list, it wouldn’t be possible to base a system purely on data, particularly at times of low liquidity. Judgment will have to play a role, leaving room for the wrongly aligned incentives for traders and those submitting data that caused some of Libor’s problems in the first place. Risks of that will be reduced by some of the proposed reforms.
A bank’s submissions will be published with a three-month delay to remove the incentive that had existed previously for banks to take account of market reaction to their data and lower submissions.
TIGHTER REGULATION
Individuals submitting the data within the banks will be subject to a new code of conduct and will be supervised by the FSA, which in turn will step up its scrutiny of Libor, and have the power to bring criminal sanctions.
And banks that currently use the benchmark but don’t contribute to it will be encouraged (or if necessary compelled through regulation) to begin submitting data to be more representative of actual rates. All these changes will reduce the risks but they won’t do away with them entirely.
Much is still yet to be decided: a tender process overseen by an independent committee was launched on Friday to choose the body that will administer Libor — Wheatley was scathing in his criticism of the BBA, describing its approach to oversight as “careless.”
However, finding a body that has the international stature, credibility and experience in governance issues, without any potential for conflicts of interest, to help restore public confidence in the system, will be a challenge — particularly as it cannot be from within the industry, and not a public body (Wheatley explicitly ruled out the FSA, arguing that it would be inappropriate for it to play a market-maker role in an industry it was meant to scrutinise).
Bloomberg and Thomson Reuters are among the bodies that are being seen as possible contenders.
Seen in this context — given the limited room for manoeuvre — the FSA’s proposed reforms to Libor are probably as extensive as they could have been, particularly at this stage.
And as Wheatley himself acknowledged, there are bigger issues that will have to be dealt with internationally and in the long term. What were the possible alternatives that could exist alongside Libor, and what kind of role, if any, should regulators play in encouraging their adoption?
There are issues that the market will have to consider regarding its approach to Libor — such as whether its use as a reference in a particular contract is indeed the suitable choice, or whether inter-bank credit and liquidity risks were even relevant to that contract in the first place.
The proposed reforms are the first step in a lengthy process of overhaul — whether Libor remains the world’s favoured benchmark, or one among several choices, is up to international regulatory authorities and the markets.